Weight issues in HDFC merger to create fresh trouble for large-cap funds

Active fund managers will be forced to remain underweight on the stock; Could have a bearing on their performance

The impending merger between Housing Development Finance Corporation (HDFC) with HDFC Bank may create challenges for large-cap fund managers, most of whom are already grappling to match the returns generated by their benchmarks.

The combined weight following the merger in the benchmark Sensex and Nifty 50 indices is likely to be much higher than permissible limits for active mutual fund (MF) schemes. This could have a bearing on the performance of large-cap funds if HDFC Bank shares outperform the markets, as the schemes will be forced to remain underweight on the stock to adhere to the single-stock cap.

Mutual fund (MF) regulations do not allow active schemes to invest more than 10 per cent in a particular stock. As of June 19, the two stocks had a combined weight of 13.9 per cent in Nifty50 and 16 per cent in the Sensex. Currently, Reliance Industries (RIL) has weight of more than 10 per cent in both Sensex and the Nifty.

With the exposure for active funds capped at 10 per cent for each stock, large-cap fund managers find themselves at a disadvantage whenever RIL stock goes through a superior run. “It is going to be a double whammy for fund managers, as both RIL and HDFC Bank have promising prospects,” said a fund manager.

According to Bloomberg data, the 12-month consensus price target for HDFC Bank is 22 per cent higher than its current price, while the upside in RIL is seen at 10 per cent.

In the past, fund managers have drawn flak for underperforming the benchmarks, which largely stemmed from not owing enough of RIL. The latest instance was during the second half of FY22, when the weight of Reliance topped 12 per cent in the indices after a strong run-up in stock price. In June 2020, the oil-to-telecom conglomerate's weight stood even higher at 15 per cent in the 50-share Nifty.

Some believe the phenomenon doesn't pose much difficulties for fund managers as the impact on performance can be cushioned through other options at fund managers' disposal.

"I don't see this as a big issue. Active largecap funds have several levers to outperform," said investment advisor and research analyst Sandip Sabharwal.

As of May-end, most active largecap funds had over 10 per cent exposure to HDFC and HDFC Bank. Fund managers say they are awaiting clarity from the Securities and Exchange Board of India (Sebi) before trimming their exposure. "It is a one-of-a-kind case. Everyone will turn underweight on HDFC Bank by design. We are awaiting clarification from Sebi before taking a call on reducing the holding," said a fund manager.

A recent news report by Reuters suggested that the market regulator was not in favour of relaxing the single stock investment cap in case of HDFC Bank even as several schemes would in a passive breach.

Active largecap funds have struggled to outperform in the recent past. An analysis done by Business Standard in January 2023 showed that almost 80 per cent active largecap funds had underperformed in calendar year 2022. However, this figure declined to 69 per cent for the 12 months ended March 2023, mostly due to slump in Adani group shares. Active largecap funds were underweight on these stocks.

"Earlier also we have seen such a situation. This will add to constraints in fund management. However, the real problem with active largecap funds is the limited universe, which leads to a high overlap in funds' portfolios and the index. At present, almost 60 per cent of active portfolios overlap with the index. This leaves a lot depending on the remaining 40 per cent of the portfolio which has to generate at least 5 per cent outperformance to be able to make the fund outperform after accounting for expenses," said Arun Kumar, VP and Head of Research at FundsIndia.

Throwing its weight

• MF regulations do not allow active schemes to invest more than 10% in a particular stock
• The 12-mth consensus price target for HDFC Bank is 22% higher than its current price
• As of May-end, most active large-caps had over 10% exposure to HDFC twins
• Both RIL and HDFC Bank have promising prospects, says a fund manager